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Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets

Authors

  • Rong Fan,

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    • Rong Fan is at Gifford Fong Associates, and Anurag Gupta and Peter Ritchken are at the Weatherhead School of Management, Case Western Reserve University. The authors would like to thank seminar participants at presentations made at the Twelfth Annual Derivatives Securities Conference in New York, the 2002 FMA European Meetings in Copenhagen, the Seventh Annual U.S. Derivatives and Risk Management Congress in Boston, the 2002 Western Finance Association Meetings in Park City, Utah, the Second World Congress of the Bachelier Finance Society in Crete, Georgetown University, and the comments of an anonymous referee. They also acknowledge support for this research from the Federal Reserve Bank in Cleveland.
  • Anurag Gupta,

    Search for more papers by this author
    • Rong Fan is at Gifford Fong Associates, and Anurag Gupta and Peter Ritchken are at the Weatherhead School of Management, Case Western Reserve University. The authors would like to thank seminar participants at presentations made at the Twelfth Annual Derivatives Securities Conference in New York, the 2002 FMA European Meetings in Copenhagen, the Seventh Annual U.S. Derivatives and Risk Management Congress in Boston, the 2002 Western Finance Association Meetings in Park City, Utah, the Second World Congress of the Bachelier Finance Society in Crete, Georgetown University, and the comments of an anonymous referee. They also acknowledge support for this research from the Federal Reserve Bank in Cleveland.
  • Peter Ritchken

    Search for more papers by this author
    • Rong Fan is at Gifford Fong Associates, and Anurag Gupta and Peter Ritchken are at the Weatherhead School of Management, Case Western Reserve University. The authors would like to thank seminar participants at presentations made at the Twelfth Annual Derivatives Securities Conference in New York, the 2002 FMA European Meetings in Copenhagen, the Seventh Annual U.S. Derivatives and Risk Management Congress in Boston, the 2002 Western Finance Association Meetings in Park City, Utah, the Second World Congress of the Bachelier Finance Society in Crete, Georgetown University, and the comments of an anonymous referee. They also acknowledge support for this research from the Federal Reserve Bank in Cleveland.

Abstract

This paper examines whether higher order multifactor models, with state variables linked solely to underlying LIBOR-swap rates, are by themselves capable of explaining and hedging interest rate derivatives, or whether models explicitly exhibiting features such as unspanned stochastic volatility are necessary. Our research shows that swaptions and even swaption straddles can be well hedged with LIBOR bonds alone. We examine the potential benefits of looking outside the LIBOR market for factors that might impact swaption prices without impacting swap rates, and find them to be minor, indicating that the swaption market is well integrated with the LIBOR-swap market.

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